Chapter 9

Perfect Competition

Lecture Plan
Market Morphology Features of Perfect Competition Demand and Revenue of a Firm Market Demand Curve and Firms Demand Curve Equilibrium of Firm Short Run Price and Output for the Competitive Industry and Firm Market Supply Curve and Firms Supply Curve Long Run Price and Output for the Industry and Firm
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Chapter Objectives
To introduce the basics of market morphology and identify the different market structures. To examine the nature of a perfectly competitive market. To understand market demand and firms demand under perfect competition. To help analyze the pricing and output decisions of a perfectly competitive firm in the short run and long run.

Market
Defined as the institutional relationship between buyers and sellers. Market refers to the interaction between buyers and sellers of a good (or service) at a mutually agreed upon price. Such interaction may be at a particular place, or may be over telephone, or even through the Internet! Sellers and buyers may meet each other personally, or may not ever see each other, as in E-commerce. Thus market may be defined as a place, a function, a process.

Market Morphology
Markets may be characterized on the basis of:
Number, size and distribution of sellers in any market Whether the product is homogeneous or differentiated Number and size of buyers:
large number of buyers but small size of individual buyer, the market will be evenly balanced between buyers and sellers. small number of buyers but their size is large, the market is driven by buyers preferences.

Absence or presence of financial, legal and technological constraints Perfect Competition Monopoly Monopolistic competition Oligopoly
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Thus we have:

Market Morphology
Type of market Number of firms Nature of product Number of buyers Freedom of entry and exit Examples

Perfect competition

Very Large

Homogeneous (undifferentiated)

Very Large

Unrestricted

Agricultural commodities, unskilled labour Retail stores, FMCG

Cars, computers, universities Indian Railways, Microsoft Indian defense industry

Monopolistic competition
Oligopoly

Many
Few

Differentiated
Undifferentiated or differentiated Unique

Many
Few

Unrestricted
Restricted

Monopoly

Single

Many

Restricted

Monopsony

Many

Undifferentiated or differentiated

Single

Not applicable

Features of Perfect Competition

Perfect competition may be defined as that market where infinite number of sellers sell homogeneous good to infinite number of buyers while buyers and sellers have perfect knowledge of market conditions

Features
Presence of large number of buyers and sellers Homogeneous product Freedom of entry and exit Perfect knowledge Perfectly elastic demand curve Perfect mobility of factors of production No governmental intervention Price determined by market and Firm is a price taker.
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Demand and Revenue of a Firm

Marginal Revenue (MR) = dP dQ = Q. dQ +P. dQ = P (1)
dTR dQ

d PQ dQ

[P is assumed to be given (constant)].

Firms are price takers and can supply as much as they want at the existing price in the market, thus: AR= MR= P(2)

Profit, Revenue and Cost Curves of a Firm

TC
Revenue, Cost, Profit TR B

Profit

Loss

Q1

Q*

Q2

Output

Maximum Profit O Q1 Q* Q2

Output

Profit () = TR - TC. Profit curve () begins from the negative axis, implying that the firm incurs losses at an output less than OQ1. At point A, i.e. output Q1 firm earns no profit no loss. Firm earns maximum profit at output OQ*. At point B, TR=TC again; profit is equal to zero, at output OQ2. Rational firm would try to maximise profit. 9

Market Demand Curve and Firms Demand Curve

The market demand curve for the whole industry is a standard downward sloping curve.
An individual buyer is able to get the maximum amount of output at each existing price, at a given time.

The market demand curve is the horizontal summation of individual demand curves.. The demand curve for an individual firm is a horizontal straight line showing that
the firm can sell infinite volume of output at the same price.

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Market Demand Curve and Firms Demand Curve

Market equilibrium is at the point of intersection (E) of the market demand and market supply curves, where equilibrium output for the industry is given at Q* and price at P*. Each perfectly competitive firm, being a price taker, takes the equilibrium price from the market as given at P*.
Market Demand

INDUSTRY
S
Market Supply Price

Price

FIRM

P*

E S

P=AR=MR

D Q* Output

Output

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Market Demand Curve and Firms Demand Curve

Since a firm can sell all it wants at this price, it faces a perfectly elastic demand curve for its product hence the demand curve is straight horizontal line. It is not worthwhile for the firm to offer any quantity at a lower price, since it can sell as much as it wants at the prevailing market price. If it tries to charge higher price its demand will fall to zero. Hence Total Revenue (TR) of a firm would increase at a constant rate, i.e. Marginal Revenue would be constant.
Average Revenue will be equal to Marginal Revenue.

Hence the demand curve, coincides with the AR and MR curves.

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Equilibrium of Firm
Two conditions must be fulfilled for a profit maximizing firm to reach equilibrium:
First order condition: MR=MC or
d dR(Q) dC (Q) dQ dQ dQ

=0

Second order condition: Slope of MR curve < MC dMR dMC curve or <0
dQ dQ

The second order condition is a sufficient condition, because if the inequality sign is reversed, we arrive at a point of loss maximization.
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Short Run Price and Output for the Competitive Industry and Firm
In short run an individual firm may be in equilibrium and may earn
Supernormal profit: Normal profit: Losses: AR>AC AR=AC AR<AC

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Supernormal Profit
Firm is in equilibrium at OQ* output at market price P*, where both the conditions of equilibrium are fulfilled. TR= OP*EQ* (TR= AR.Q) TC= OABQ* (TC=AC.Q) Profit = AP*EB = (OP*EQ*-OABQ*) This is the supernormal profit made by the firm in the short run, because the market price P* (AR) is greater than average cost.

AR>AC
Price

MC E B

AC

P* A

AR=MR

Q *

Quantity

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Supernormal Profit
Firm is in equilibrium at OQ* output at market price P*, where both the conditions of equilibrium are fulfilled i.e. point E. TR= OP*EQ* (TR= AR.Q) TC= OABQ* (TC=AC.Q) Profit = AP*EB = (OP*EQ*-OABQ*) This is the supernormal profit made by the firm in the short run, because the market price P* (AR) is greater than average cost.
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AR>AC
Price

MC E B

AC

P * A

AR=MR

Q *

Quantity

Normal Profit
AC=AR=MC=MR
Price

MC E

AC

P*

AR=MR

Q *

In the short run some firms may earn only normal profit (when average revenue is equal to average cost). Firm is in equilibrium at OQ* output at market price P*, where both the conditions of equilibrium are fulfilled. TR= OP*EQ* TC= OP*EQ* TR=TC Firm makes normal profit, and actually ends up producing at the break even level of output.

Quantity

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Subnormal Profit (or Loss)

Price

AR<AC
MC AC

A P*

B E
AR=MR

Q*

Quantity

Firm is in equilibrium at OQ* output at market price P*, where both the conditions of equilibrium are fulfilled (point E). TC= OABQ* TR= OP*EQ* Loss= P*ABE = OP*EQ* - OABQ* The firm incurs loss or subnormal profit in the short run because the AC of producing this output is more than the market price hence TR<TC. The firm continues to produce at loss in the short run in anticipation of price rise.
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Exit or Shut Down of Production

FIRM
Price
MC AC AVC AVC A

P*

AR=M R

Q*

Quantity

A firm incurring losses in the short run will not withdraw from the market, but will wait for market conditions to improve in the long run. Firm would continue production till price > average variable cost (P>AVC or AR>AVC). Point A denotes the shut down point, where price P* = AVC=AR. Any increase in VC above A or any fall in market price below P* will cause the firm to shut down.

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Market Supply Curve and Firms Supply Curve

Condition I: If Price<minimum AVC, then shut down
For such price, the supply curve would coincide with the vertical axis.

Condition II: If Price minimum AVC, then choose any output that would maximize profit. For any price above minimum AVC, the firm would choose an output level that would satisfy the conditions of profit maximization.
The supply curve of the firm would be identical to the short run marginal cost curve above the minimum point of the AVC curve.

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Long Run Price and Output for the Industry and the Firm
In the long run perfectly competitive firms earn only normal profits. AR=MR=MC=AC The reason is the unrestricted entry into and exit of firms from the industry in the long run. When existing firms enjoy supernormal profits in the short run new firms are attracted to the industry to gain profits.
The supply of the commodity in the market increases. Assuming no change in the demand side, this lowers the price level.

When firms are making losses in the short run, some may be forced to leave the industry in the long run.
Their exit from the industry causes a reduction in the supply of the product and as a result the equilibrium price rises.

This process of adjustment continues up to the point where the price line becomes tangential to the AC curve.
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Long Run Price and Output for the Industry and the Firm
Price

P1 P* P2 O

Prevailing price is OP1, Equilibrium at Point E1 and AR=MR=MC=AC Output OQ1 Firms earn supernormal LMC profit (AR>AC) LAC This will attract more firms, E1 increase in supply will reduce E* AR=MR the price till AC=AR, i.e. at P* E2 Prevailing price is OP2, Equilibrium at Point E2 and Output OQ2 Firms earn loss (AR<AC) Q2 Q* Q1 Quantity Some firms will exit, decrease in supply will increase the price till AC=AR, 22 i.e. at P*

Summary
A market is a place / process of interaction between sellers and buyers that facilitates exchange of goods and services at mutually agreed upon prices. Perfect competition is defined as a market structure which has many sellers selling homogeneous products at the market price. The equilibrium price is determined by demand and supply in the market Each firm sells a very small portion of the total industry output; hence it can not affect the price in the market and has to accept the price given to it by the market. As such, it is regarded as a price taker. A firm faces a perfectly elastic demand curve; hence average revenue is constant and is equal to marginal revenue. Profit maximizing output is that where marginal cost is equal to marginal revenue while marginal cost is increasing.

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Summary
In the short run firms can earn supernormal profits, or normal profits, or even loss. This depends on the position of the short run cost curves. The supply curve of the firm would be identical to the short run marginal cost curve above the minimum point of the AVC curve. The industry supply curve is obtained by the horizontal summation of the supply curves of all firms in the industry. In the long run perfectly competitive firms earn only normal profits. If firms are making supernormal profits in the short run, this would attract new firms and if firms are incurring losses; some firms would exit the market, leaving existing firms with normal profits in either case.

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